# Underatanding Risk & Attitudes towards Risk together with a Comparative Perspective between Expected Utility Maximization & Prospect Theories

MIB Session 1: Dec 27, 2012 Prof. Samar K. Datta

Sub-topics to be discussed
• Two ways to model risk

• Preferences toward risk
• Mechanisms for reducing risk • Where does Prospect Theory differ?

Standard deviation measuring risk
• Deviations or differences between expected payoff and actual payoff are important – The standard deviation measures the square root of the average of the squares of the deviations of the payoffs associated with each outcome from their expected value.

the variability is not. densities Which distribution would you prefer.Why SD important? f(X). but sd(X) >sd(Y) . Y E(X)=E(Y). if you are risk-averse? While the expected values are the same. Greater variability from expected values signals greater risk. X. g(Y) = prob.

Approaches to model risk-averseness • Assumptions for choosing among risky alternatives – Consumption of a single commodity – The consumer knows all probabilities – Payoffs measured in terms of utility – Utility function given • Approach 1: Max U [E(income). SD(income)] (+) • Approach 2: Max E[U(income)] (-) .

5 probability of \$30. 10 Risk averseness means gain valued less than loss at the margin 0 10 15 16 20 30 Income (\$1.000 to a gamble with a 0.Risk Averse Prefernces Toward Risk Utility E D C B A 18 16 14 13 The consumer is risk averse because she would prefer a certain income of \$20.5 probability of \$10.000) .000 and a 0.000.

A 6 Risk neutrality means gain valued same as loss at the margin 0 10 20 30 Income (\$1.Risk Neutral Preferences Toward Risk E Utility 18 A person is said to be risk neutral if he shows no preference between a certain income.000) . and an uncertain one with the same expected value. C 12 The consumer is risk neutral as he is indifferent between certain events and uncertain events with the same expected income.

criminal activity E The consumer is risk loving because she would prefer the gamble to a certain income. 8 A 3 0 10 C Risk loving behavior mean gain valued more than loss at the margin 20 30 Income (\$1.Risk Loving Preferences Utility 18 From rapid growth of casinos almost everywhere.000) . is it proper to argue that most countries are becoming nations of gamblers? A person is said to be risk loving if he shows a preference toward an uncertain income over a certain income with the same expected value. Examples: gambling.

• The greater the concavity of the utility curve. • R = U[E(Y)] – E[U(Y)] in utility terms • It can also be measured along the horizontal axis in terms of money • The greater the variability – i. the greater the risk premium.Notion of Risk Premium • The risk premium is the amount of money that a risk-averse person would pay to avoid taking a risk.e. the spread of values of the random variable around mean. the greater the risk premium – it means a much higher weight is assigned to a decline in income as compared to an equal amount of rise in income ..

000.Estimating Risk Premium Utility Risk Premium in money terms G 20 18 14 Here .000 gives the person the same expected utility as the uncertain income that has an expected value of \$20. Risk premium in utility terms E C A F 10 0 10 16 20 30 40 Income (\$1. the risk premium is \$4.000) .000 because a certain income of \$16.

Meaning of High Degree of Risk Aversion U3 Expected Income U2 U1 Here increase in Standard deviation requires a large increase in income to maintain satisfaction. Standard Deviation of Income .

U3 U2 U1 Standard Deviation of Income .Meaning of Low Degree of Risk Aversion Expected Income Slightly Risk Averse => A large increase in standard deviation requires only a small increase in income to maintain satisfaction.

Indifference curves of riskneutral & risk-loving people • Risk-neutrality means horizontal indifference curve showing zero premium the consumer is willing to pay to buy hedge against risk (i.e.e. he doesn’t mind bearing more risk) • Risk-lover willing to pay (i... make sacrifice in terms expected income) to enjoy the thrill of greater risk-bearing – thus making indifference curves usual downward sloping .

while as a risk seeker spend a small amount (on lottery) to seize small chance of a large gain. a rise averter will spend small amount to buy insurance against small chance of large loss.Utility function of a person who buys insurance and gambles too! Total utility TU curve Concave to horizontal axis Convex to horizontal axis A Near point of inflection. Income . A (MU at its minimum).

.Risk Reduction Strategies • Three ways consumers attempt to reduce risk are: 1) Diversification 2) Insurance 3) Obtaining more information • Firms can reduce risk by diversifying among a variety of activities that are not closely related.

guarantee of same income regardless of outcome has higher utility than facing the probability of risk • Expected utility with insurance is higher than without • Purchases of insurance transfers wealth and increases expected utility – Actuarial Fairness: When the insurance premium = expected payout . risk averse people will buy enough insurance to recover fully from a potential financial loss • For the risk averse consumer.Reducing Risk – Insurance • Risk averse are willing to pay to avoid risk • If the cost of insurance equals the expected loss.

Important Issues on Insurance • Formal insurance always needed or available to hedge against any risk? • Will supplier of insurance be necessarily a risk-lover? What about buyer of insurance? • Is provision of insurance always possible? • Does supplier of insurance also need insurance? .

y = -d[log U’(y)]/d[logy] = -[U’’(y)/U’(y)]/[dy/y] =-[U’’(y).U’’(y)/U’(y) • Relative risk-aversion.y]/U’(y) .Arrow-Pratt Risk-aversion Measures • Absolute risk-aversion.r. A(y) = -d[u’(y)]/d[u(y)] = . R(y) = Elasticity of U’(y) w.t.

R(y)=a . A(y)=2b/(a-2by). A(y)=a.b>0 for 0≤y≤a/2b.Some commonly used utility functions 1. R(y)=2by/(a-2by) 3. a≥0. U = 1 – e-ay. U = ay – by2. R(y)=ay 2. U=[1-y(1-a)]/(a-1). a. a>0. A(y)=a/y.

systematically. The issue. • Evidence suggests that we reach decisions in accord with an underlying structure that enables us to function predictably and. however. is the degree to which the reality in which we make our decisions deviates from the rational decision models .A counter-perspective of Prospect Theory  The classical models of rationality specifies how people should make decision in the face of risk. rather. reveal that departures from that model occur more frequently than most of us admit. in most instances. Extensive experimentation.

people are often unable to understand fully what they are dealing with.First. • Also difficulty in sampling. • Result: We pay excessive attention to lowprobability events accompanied by high drama and overlook events that happen in routine fashion. They experience what psychologists call cognitive difficulties. as we have a hard time drawing valid generalizations from what we observe. emotion often destroys the self-control that is essential to rational decision-making.Kahneman and Tversky: Differences mainly due to two human shortcomings • . Second. .

.Example: how initial perceptions mislead us • Ask yourself whether the letter K appears more often as the first or as the third letter of English words. You will probably answer that it appears more often as the first letter. Why the error? We find it easier to recall words with a certain letter at the beginning than words with that same letter somewhere else. K appears as the third letter twice as often. Actually.

• People are much more sensitive to negative than to positive stimuli. Losses will always loom larger than gains.” writes Tversky (italics added). but the number of things that would make us feel worse is unbounded.Findings of Prospect Theory • Asymmetry between the way we make decisions involving gains and decisions involving losses is one of the most striking findings of Prospect Theory. • “The major driving force is loss aversion. they hate losing”. . “It is not so much that people hate uncertainty but rather. There are few things that would make us feel better.

. Program B: 33% probability that everyone will be saved and 67% probability that no one will be saved.Example of Loss-aversion A rare disease breaking out in some community expected to kill 600 people. In the experiment. 72% of the subjects chose the risk-averse response represented by Program A. Rational risk-averse people will prefer Plan A’s certainty of saving 200 lives over Plan B’s gamble. which has the same mathematical expectancy but involves taking the risk of a 67% chance that everyone will die. Two programs available to handle the threat: Program A: 200 people will be saved.

Note first of the two choices expressed in terms of 400 deaths rather than 200 survivors. .Identical problem posed differently Program C: 400 of the 600 will die. while the second program offers a 33% chances that no one will die. Program D: 33% probability that nobody will die and 67% probability that 600 people will die. Kahneman and Tversky report that 78% of their subjects were risk-seekers and opted for the gamble: they could not tolerate the prospect of the sure loss of 400 lives.

Advertisement may thus change the perspective of a buyer. . might persuade them to refrain from buying. but psychologically unfeasible. intuitively compelling. The manner in which questions are framed in advertising may persuade people to buy something despite negative consequences that. in a different frame.Further findings Invariance is normatively essential (what we should do).

only about 20% favored radiation. more than 40% of the choices favored radiation. When the question was put in terms of life expectancy.An Example Medical data in hospital showed that no patients die during radiation but have shorter life expectancy than patients who survive the risk of surgery. . the overall difference in life expectancy was not great enough to provide a clear choice between the two forms of treatment. When the question was put in terms of risk of death during treatment.

Findings of the theory of Mental Accounting • Loss is less painful when it is just an addition to a larger loss than when it is a free-standing loss. Kahneman and his wife bought all their furniture within a week after buying the house. . If they had looked at the furniture as a separate account. • Example: when moving into a new home. they might have balked at the cost and ended up buying fewer pieces than they needed.

• Ambiguity Aversion means that people prefer to take risks on the basis of known rather than unknown probabilities. .Role of Information & Ambiguity Aversion • Information is a necessary ingredient to rational decision-making and more information offer opportunities for people in authority to manipulate the kinds of risk that people are willing to take.

Yet the overwhelming preponderance of the respondents close to bet on the draw from Urn 1.Example and implications of Ambiguity Aversion Example: Ellsberg offered several groups of people a chance to bet on drawing either a red ball or a black ball from two different urns. the breakdown in Urn 2 was unknown. Ambiguity aversion is driven by the feeling of incompetence and will be present when subjects evaluate clear and vague prospects jointly. but it will greatly diminish or disappear. each holding 100 balls. when they evaluate each prospect in isolation. Probability theory would suggest that Urn 2 was also split 50-50. Urn 1 hold 50 balls of each color. as there was no basis for any other distribution. .

although not always rational in the traditional sense of the word. there is no basis for the argument that behavior is going to be random and erratic merely because it fails to provide a perfect match with rigid theoretical assumption. .Final Implications for Theories of Choice Evidence indicates that human choices are orderly. Since orderly decisions are predictable.

Many catastrophic errors of judgment are thus either avoided. Consequently. from FATE and ORIGINAL DESIGN to sophisticated. and from helplessness to choice.Conclusion • The science of risk management sometimes creates new risks even as it brings old risks under control. or else their consequences are muted. • Hence there is a transformation in the perception of risk from chance of loss into opportunity for gain. • Example: Seatbelts encourage drivers to drive more aggressively. the number of accidents rises even though the seriousness of injury in any one accident declines. . probability-based forecasts of the future.